Investing in Real Estate Will Be Revolutionized By Crowdfunding (Part I)

A once-abandoned commercial building will soon get a face lift from local Washington, D.C., investors through Fundrise.

While most Americans are homeowners and invest in residential real estate, relatively few invest in commercial real estate. Instead, these nonresidential properties have largely been reserved for the wealthiest elite investors.

With the introduction of crowdfunding, however, the real estate market is set to become more democratic. Thanks to the JOBS Act, this new investing platform will give small-time investors the chance to directly fund commercial properties.

To provide insight into this new market, The Motley Fool has compiled a special series that takes a look at different perspectives on crowdfunding. We started by interviewing multiple entrepreneurs, including Ben Miller, the founder of real estate start-up Fundrise. Miller's story, told in two parts, reveals a real estate market corrupted by Wall Street money over the years, desperately in need of radical change through everyday retail investors.

Before big money, there was local moneyHistorically, real estate development in America was a highly local endeavor. As a vast country became more urbanized, cities and downtown areas were formed according to the needs of local economies. It was commercial real estate – the buildings of businesses and retail – that helped shape downtowns, which would vary from city to city. The businesses along Main Street in Charleston, W.Va., for example, would have a different look and feel than those in Charleston, S.C.

But it wasn't just the contrast between mountainous West Virginia and coastal Carolina that made those Main Streets unique. What really shaped towns were the builders, the developers, and, most importantly, the investors. They were the backers for real estate projects, and up until the late 1980s they were typically well-heeled local families and companies.

Ben Miller is intimately familiar with the evolution of commercial real estate in his hometown of Washington, D.C. His family, through WestMill Capital Partners, has been deeply involved in commercial real estate for decades. He describes the prevalence of local investors in the pre-1990s real estate market:

If you look at how the real estate industry used to work before 1990 -- let's just say that '90 is a line -- it was a lot of insurance companies. Families were the big players in real estate. Like, if you're in D.C., the Cafritz family, the Carr family, Albert Small, Charles E. Smith -- these were huge real estate families.

By the early '90s, however, that was about to change. A series of major events upended the traditional commercial real estate industry, altering the core of many American cities.

A real estate bonanza gone bustIn America, not a decade seems to pass without a significant shock to the financial markets. In the mid-1980s, that shock was the Savings and Loan crisis, which crippled more than 2,000 financial institutions and stuck the U.S. government with a $100 billion liability. The government's response, in turn, permanently changed the real estate landscape.

While the causes of the S&L crisis are varied, the major culprit was bank speculation in the real estate market.

In an attempt to goose profits, banks poured money into commercial real estate, the hottest asset of the moment. Real estate loans grew from 10% of overall lending prior to 1980 to 50% to 60% by the middle of the decade. But the commercial real estate game was new to many of these lenders, and the market quickly overheated. As described by William Seidman, former chairman of both the Federal Deposit Insurance Corp. (FDIC) and the Resolution Trust Corp. (RTC):

The critical catalyst causing the institutional disruption around the world can be almost uniformly described by three words: real estate loans. In the U.S., the problem was made even worse by allowing S&Ls to make commercial real estate loans in areas they knew little about.

The mantra of the day became, "A builder will build if a financer will finance." But these new financiers (investors), unlike the traditional insurance companies and families that came before, were not investing in real estate for the long haul. They knew little and cared less about the quality of what was being built. Instead, real estate was just a physical asset that, hopefully, would hold its value following a period of rampant inflation. So, they kept dancing until the music stopped.

The explosion of REITs and private equityBy the mid-1980s, the construction frenzy reached its crescendo. The only place for real estate prices to go was down, but by then a steep decline in value would send thousands of S&Ls belly up. So, what to do?

Before things got out of hand, the U.S. government stepped in. The FDIC and RTC took over the S&Ls, sold their remaining deposits to other institutions and then liquidated the rest, which was mostly real estate.

But, as the chairman of the RTC and FDIC would later describe, this was "the biggest mistake my administration made.... We learned it is much more efficient and quicker to maintain the failed institution, manage it, and sell the assets from there."

So, the RTC basically conducted a garage sale with thousands of properties worth hundreds of billions of dollars. As Miller explains, "It's this insane, insane amount of real estate.... The government basically, they couldn't sell the real estate one by one. It just wouldn't work, so they just started selling them in big pools -- packages."

Once packaged, the pools were sliced and diced and sold to very willing buyers in both the public markets -- through real estate investment trusts (REITs) -- or in the private markets to emerging private equity players such as Goldman Sachs' Whitehall, JER Partners, and the Bass Brothers' Oak Hill Capital.

This fire sale was almost too good to be true for the buyers, and the REIT market continued to grow nearly unabated for 15 years.

Source: National Association of Real Estate Investment Trusts

The story was similar for private equity. As expected, the initial returns on these investments were tremendous, which only perpetuated the trend. As Miller points out:

When they're buying these portfolios and selling them 5 years later, 7 years later, they made a lot of money. Huge returns. They just killed it. And that really validated the market. The more money they made, the more money they could raise. The more private equity funds got started, and the more pension funds started investing in it.

Miller refers to this as the "financialization of real estate," when the typical buyer of real estate shifted from a real estate expert with an understanding of a local market to a massive fund, purchasing in vast pools. Not surprisingly, the desired holding period for these assets shrunk as well, as P/E funds took a 40-year real estate asset and expected to generate a healthy return on investment in five to seven years. In the case of REITs, which have a quarter-to-quarter mandate, that time frame grew even shorter.

The interests of the fund became detached from those of the developer, not to mention the tenants or communities involved.

A disastrous misalignmentDespite the deep real estate expertise of traditional investors, the local money and real estate families went by the wayside -- or went public. The big real estate money took over and became the driving influence on communities across America.

This was detrimental in a few ways.

Main Street became a commodity. Without a deep understanding of local markets, a Wall Street numbers-driven mentality took over. The bottom-line became the end all, be all.

A 'herd mentality' took over development. A city's unique needs mattered less and less to distant investors, so business districts and shopping centers everywhere turned into homogenous developments. Why roll the dice on a local restaurant entrepreneur when a generic chain will fit the bill? This, ultimately, led to a herd mentality for developers in most cities, which is all too similar to what can happen to mutual fund managers. Why stick your neck out when you can just follow the crowd and generate an average product?

You have this insane growth in suburbs for like 40-50 years. How do you build in a greenfield? It's just greenfield. There's no context; no social context, no cultural context, no historic context, no architectural context.

The parties involved willingly selected the path of least resistance. In the short run, it's the easy money, right?

It's this short-termism that really sets off a developer like Miller. It strips real estate of any nuance, of any concern for externalities for the tenants, their neighbors, or communities. In fact, the only way for communities to really influence development was through groups like NIMBY, which is anti-development -- it stands for Not in My Backyard.

For megafunds, Miller suggests, "It's just not relevant to them. They do not care. Their bonuses aren't tied to it, and so it's just everything wrong with real estate investing."

How crowdfunding can rewrite the rulesIt might be easy, in hindsight, to identify why this approach fails in the long run, but reversing course poses a daunting challenge. Private equity and REITs now account for over a trillion dollars in real estate assets. Still, crowdfunding companies such as Fundrise are willing to test a new approach.

And the JOBS Act, which has yet to be fully implemented, could provide a much-needed catalyst. Fundrise has already advanced the crowdfunding concept in DC through special offerings conducted under SEC Regulation A. Over time, this platform will roll out nationwide, providing every American with an opportunity to invest in their own neighborhood. Like the local families who came before, these are the people who understand what should be built and how it should take shape.

Miller points out, "People are invested in nothing local. Everything's remote, everything's on Wall Street, everything's in mutual funds." Crowdfunding might change all of that, and rewrite the rules of real estate investing in the process.

Author

Isaac covers the companies that constantly push the world forward, from the engines of innovation like GE and Google to the rule breakers like Chipotle and Whole Foods. He admires the leaders that embody the philosophy of Conscious Capitalism.
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